The Reserve Bank says a larger housing correction could be on the cards, as house prices remain above sustainable levels.
Housing in Mount Victoria, Wellington. Photo: RNZ / Dom Thomas
House prices have declined 4 percent since their peak last November, after rising 48 percent over two years.
The central bank's half yearly financial stability report, said recent buyers with limited equity are vulnerable to declines, and a large fall would significantly reduce wealth and lead to less consumer spending.
It said the high house prices, the war in Ukraine and the Omicron outbreak, mean near-term risks to the financial system have increased.
But the RBNZ said New Zealand's financial system remains well placed to support the economy. It also did not rule out a global recession in the coming months.
However, the housing market continued to pose a risk to the economy.
"While a gradual decline in house prices to more sustainable levels is desirable from a financial stability perspective, a sharp correction remains a plausible outcome that would have broad economic implications.
"Relative December 2021 prices, we estimate that a 30 percent fall in house price could lead to around 10 percent of all outstanding mortgage debt to fall into negative equity (the value of the borrower's property being less than the outstanding mortgage amount)," the report said.
The report said debt-servicing costs will increase significantly as current fixed-rate mortgages re-price over the coming year.
"Some recent mortgage borrowers are vulnerable and could face difficulty servicing their debts, but overall the threat to the financial system is limited."
But it meant some households will need to tighten their belts to manage the impact on their finances.
It said banks kept test interest rates in their serviceability assessments at about 6 percent, above the current mortgage rates, providing some reassurance that buffers were in place.
It said households balance sheets remained strong and loan-to-value ratio restrictions have limited the build up of risky debt as house prices increased.
"Debt servicing vulnerabilities do not pose a significant threat to the stability of the financial system at current mortgage rates, although some more vulnerable households could face stress from a combination of further significant increases in mortgage rates and living costs," the report said.
The RBNZ said similar to households, debt servicing costs for businesses are also increasing with interest rates.
But on its own, the bank said it was unlikely to cause financial strain given the low starting point of interest rates and general deleveraging by businesses over the past few years.
"However, when combined with other cost pressures and reduced spending due to the Omicron outbreak, some businesses are likely to become stressed."
It said low interest rates during the pandemic saw debt servicing costs decline, increasing borrowing capacity and the share of new lending at high-debt-to-income ratios (DTI).
But the RBNZ reaffirmed that it was proceeding to design a framework for setting up DTI restrictions.
It said analysis showed first home buyers would be least affected by a DTI restriction, with investors impacted the most as they tended to borrow at higher DTIs than other groups.
The RBNZ planned to have the framework finalised by late this year, so that restrictions could be introduced by mid-2023 if needed.
It also said rental yields remained historically low as interest rates continued to rise, meaning rental property has become a less attractive investment.
"This points to increased pressure for rents to grow, or for house prices to decline, to bring rental yields in line with returns on other assets," the bank said.